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Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting

Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting

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Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifes a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be ineciently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.
Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifes a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be ineciently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

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Published by: Brookings Institution on Mar 27, 2014
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Abstract
Financial markets are incomplete, thus for many households borrowing is possible only by accepting a
nancial contract that species a xed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefciently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete nancial markets when incomplete contracts are written in terms of money. By insulating households’ nominal incomes from aggregate real shocks, this policy effectively completes nancial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete nancial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict ination targeting.
Debt and Incomplete Financial Markets:A Case for Nominal GDP Targeting
Kevin D. Sheedy, London School of Economics
Final conference draft
Brookings Panel on Economic Activity March 20–21, 2014
 
Debt and Incomplete Financial Markets:A Case for Nominal GDP Targeting
Kevin D. Sheedy
London School of EconomicsFirst draft: 7
th
February 2012This version: 10
th
March 2014
Abstract
Financial markets are incomplete, thus for many households borrowing is possible only byaccepting a financial contract that specifies a fixed repayment. However, the future income thatwill repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that amonetary policy of nominal GDP targeting can improve the functioning of incomplete financialmarkets when incomplete contracts are written in terms of money. By insulating households’nominal incomes from aggregate real shocks, this policy effectively completes financial marketsby stabilizing the ratio of debt to income. The paper argues the objective of replicatingcomplete financial markets should receive substantial weight even in an environment withother frictions that have been used to justify a policy of strict inflation targeting.
JEL classifications:
 E21; E31; E44; E52.
Keywords:
 incomplete markets; heterogeneous agents; risk sharing; nominal GDP targeting.
I thank Carlos Carvalho, Wouter den Haan, Monique Ebell, Cosmin Ilut, Albert Marcet, MatthiasPaustian, David Romer, and George Selgin for helpful comments. The paper has also benefited from thecomments of seminar participants at Banque de France, U. Cambridge, CERGE-EI, ´Ecole Polytechnique,U. Lausanne, U. Maryland, National Bank of Serbia, New York Fed, U. Oxford, PUC–Rio, S˜ao Paulo Schoolof Economics, U. Southampton, U. St. Andrews, U. Warwick, the Anglo-French-Italian Macroeconomicsworkshop, Birmingham Econometrics and Macroeconomics conference, Centre for Economic Performanceannual conference, Econometric Society North American summer meeting, EEA annual congress, ESSET,ESSIM, Joint French Macro workshop, LACEA, LBS-CEPR conference ‘Developments in Macroeconomicsand Finance’, London Macroeconomics workshop, Midwest Macro Meeting, and NBER Summer Institutein Monetary Economics.
LSE, CEP, CEPR, and CfM. Address: Department of Economics, London School of Economics and Political Science, Houghton Street, London, WC2A 2AE, UK. Tel:
 +44 207 107 5022
, Fax:
 +44 207 9556592
, Email:
, Website:
.
 
1 Introduction
At the heart of any argument for a monetary policy strategy lies a view of what are the mostimportant frictions or market failures that monetary policy should seek to mitigate. The canonical justification for inflation targeting as optimal monetary policy rests on the argument that pricingfrictions in goods markets are of particular concern (see, for example, Woodford, 2003). With infrequent price adjustment owing to menu costs or other nominal rigidities, high or volatile inflationleads to relative price distortions that impair the efficient operation of markets, and which directlyconsumes time and resources in the process of setting prices. Inflation targeting is the appropriatepolicy response to such frictions because it is able to move the economy closer to, or even replicate,what the equilibrium would be if prices were flexible. In other words, inflation targeting is able toundo or partially circumvent the frictions created by nominal price stickiness.
1
This paper argues that nominal price stickiness may not be the most serious friction that mone-tary policy has to contend with. While the use of money as a unit of account in setting infrequentlyadjusted goods prices is well documented, money’s role as a unit of account in writing financialcontracts is equally pervasive. Moreover, just as price stickiness means that nominal prices fail tobe fully state contingent, financial contracts are typically not contingent on all possible future statesof the world, for example, debt contracts that specify fixed nominal repayments. Financial contractsmight not be fully contingent for a variety of reasons, but one explanation could be that transactioncosts make it prohibitively expensive to write and enforce complicated and lengthy contracts. Manyagents, such as households, would find it difficult to issue liabilities with state-contingent repay-ments resembling equity or derivatives, and must instead rely on simple debt contracts if they areto borrow. Thus, in a similar way to how menu costs can make prices sticky, transaction costs canmake financial markets incomplete.This paper studies the implications for optimal monetary policy of such financial-market incom-pleteness in the form of non-contingent nominal debt contracts.
2
The argument can be understoodin terms of which monetary policy strategy is able to undo or mitigate the adverse consequences of financial-market incompleteness, just as inflation targeting can be understood as a means of circum-venting the problem of nominal price stickiness. For both non-contingent nominal financial contractsand nominal price stickiness, it is money’s role as a unit of account that is crucial, and in both cases,optimal monetary policy is essentially the choice of a particular nominal anchor that makes moneybest perform its unit-of-account function. But in spite of this formal similarity, the optimal nominal
1
In addition to the theoretical case, the more practical merits of implementing inflation targeting are discussed inBernanke, Laubach, Mishkin and Posen (1999).
2
It is increasingly argued that monetary policy must take account of financial-market frictions such as collateralconstraints or spreads between internal and external finance. These are different from the financial frictions empha-sized in this paper. Starting from Bernanke, Gertler and Gilchrist (1999), there is now a substantial body of work that integrates credit frictions of the kind found in Bernanke and Gertler (1989) or Kiyotaki and Moore (1997) into monetary DSGE models. Recent work in this area includes Christiano, Motto and Rostagno (2010). These frictions can magnify the effects of both shocks and monetary policy actions and make these effects more persistent. Butthe existence of a quantitatively important credit channel does not in and of itself imply that optimal monetarypolicy is necessarily so different from inflation targeting unless new types of financial shocks are introduced (Faia andMonacelli, 2007, Carlstrom, Fuerst and Paustian, 2010, De Fiore and Tristani, 2012).
1

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